Opinion

Regulation in the time of COVID: fincrime and Brexit

Gavin Stewart Gavin Stewart

Financial services regulation is adapting to an evolving world. Gavin Stewart's daily blogs cover all the latest news.

This week's series of blogs covers financial crime, modern banking and an update on the Financial Conduct Authority (FCA).

Fincrime: London's Achilles'​ heel

Financial crime is one of three major external threats to the UK financial system, alongside cyber and climate risk. This already serious problem is made more damaging by the combination of Brexit and Joe Biden's arrival in the White House.

Both the potential use of London as a 'laundromat' and the UK's overseas territories, with their tax haven secrecy laws, will inevitably become more of a target for scrutiny and criticism from other regulators.

I've written regularly about financial crime being very much the poor relation of the regulator's objectives. This was true of the Financial Services Authority (FSA), and is even more of the FCA. Particularly since fincrime's status was downgraded to a constituent part of the regulator's market integrity objective, rather than being an objective in its own right.

Central to this is the seriousness and, just as important, consistency with which the regulator enforces firms' compliance with the Know Your Customer (KYC) rules. This is time-consuming and largely thankless work for supervisors, and it's easy for an executive committee and board to deprioritise in favour of quicker wins.

As the UK looks to open its markets further, our regulatory standards of due diligence and transparency, together with KYC, will become litmus tests for what sort of international financial centre London wants to be.

At present, the FCA has neither the mix of resources nor the mindset to meet this challenge successfully. Unless its approach becomes markedly more expansive, and as much 'bite' as 'bark', London's reputation is likely to suffer further.

The smaller banks'​ conundrum

Last week's speech by Vicky Saporta, the Prudential Regulation Authority's (PRA) Executive Director, Policy, is a significant addition to the growing narrative of how to regulate smaller banks safely, but in a way that doesn't unreasonably inhibit their growth or impose unnecessary costs.

Other recent contributions include Sam Woods' speech at the Mansion House and Mel Beaman's letter on collections' processes in non-systemic banks.

The conundrum is a real one. With banking in particular, size has a direct relation to the potential systemic risk a firm carries and so, especially since the financial crisis, there are significantly greater safeguards and obligations on banks above a certain size.

At its simplest, the dilemma revolves around three questions:

1 Where to draw the line?

2 How to manage the transition?

3 How much less should be the obligations on smaller banks?

It's good to see the PRA engaging seriously with these questions, but we shouldn't be under any illusion that there's a simple answer. Or that, when push comes to shove, the PRA will err on the cautious side.

At the margin, this probably matters less than it should. UK banking is tightly consolidated, and the incumbents are arguably more secure now, given the government's use of them as a policy instrument.

Meanwhile, scale is dauntingly hard to achieve organically and would require massive investment. The PRA's fit and proper test for new owners of existing banks is rather more challenging than the Premier League's. And if the UK is no longer a rule-taker from the EU, there are still international standards to adhere to, notably Basel; so the realistic prospect for easing regulation will remain less than some would wish.

Central Bank Digital Currency

Only a few months ago, whether the UK would have a Central Bank Digital Currency (CBDC) in the near future was a major question, but this now seems a done deal and the questions have shifted from 'if' to 'when' and 'how'.

A couple of weeks ago, we had the announcement of a joint Treasury (HMT) and Bank of England (BoE) Taskforce and, while its official remit is to "explore" the issue, it's not hard to conclude from the infrastructure being built around it - notably a CBDC Unit in the BoE, that the fundamental decision has been taken.

CBDCs raise a raft of issues, not least around financial crime, the potential disintermediation of banks and financial inclusion. Doubtless all these will be on the Taskforce's agenda, but it would be wrong to assume that any of them can be 'fixed' in the normal sense.

For example, I don't detect any sense in the UK of wanting to disintermediate the banking sector, but other central banks and governments might take a different view. Once the option exists, it can't be taken off the table entirely.

Despite its best attempts, the respective cultures of HMT and the BoE will also tend towards the operational more than the strategic, and it wouldn't be a surprise if the resulting report was superb on the technical challenges, but weaker on how to manage the long-term implications.

One obvious possible effect, which will concern some at the FCA and PRA, is that a CBDC deepens the UK's K-shaped recovery from COVID-19, accentuating inequalities in ways that are hard to bridge.

For all the attractions, and there are many, CBDC is a Pandora's Box, and the Taskforce will need to cast its net much wider than usual to start to prepare us for the challenges it will bring.

Property market complexity

UK regulators - PRA, FCA and the FPC - will be looking askance at the growing complexity of the UK property market. The most obvious element is the still-inflating residential mortgage bubble caused by the stamp market holiday, now due to end in August.

Net borrowing in March was the highest since April 1993. Back then, interest rates, house prices and sterling had all plummeted after Black Wednesday the previous September, so being able to compare current demand to then doesn't augur well.

The complexity doesn't end there, however. The fallout from Grenfell affects both cost of building affordable homes and those living in homes where unsafe cladding and other related safety failings has slashed the value. Meanwhile, the moratorium on commercial rental evictions is due to end on 30 June, with the next steps far from clear.

I've posted before about the high level of regulatory uncertainty in the current situation and this show no signs of decreasing. Both HMT and the FCA - with its temporary regulations (posts passim) - have a major challenge to navigate their withdrawal of support.

At present, it's hard not to imagine there will be a significant drop in the UK property market. How big and how fast is what regulators will be trying to model but the complexity becomes ever more daunting.

Outcomes'​ realism (finally)

It's rare to read a major speech on regulation that explicitly walks through the history of an issue and recognises its complexity and difficulty. This speech on regulatory outcomes, by Charles Randell (FCA Chair) joins that select group and builds on a broader speech of his a couple of weeks ago.

At the time, I outlined three core problems the FCA would need to overcome to make outcomes-based regulation work:

1 The influence of the macroeconomy

2 Finding metrics that work

3 The long-term nature of the effort required.

I was closely involved with the FSA's approach to outcomes and the speech summarises this history well, covering the first two problems and using the same examples of the financial crisis and TCF to illustrate. However, it only really alludes to the third problem, the long-term effort required.

This comprises several different challenges, but two of the most damaging are:

1 Objective interpretation of the metrics

2 The attention span of executive committee and board, given the pace of events they have to deal with

Taking these briefly in turn...

On 1: few outcomes can be measured by single metrics - typically, you need a basket of proxies, and all can be challenged; so building a credible story involves acknowledging the imperfections and not overclaiming, both of which have proved to be a challenge.

Regarding 2, executive committees and boards have consistently not wanted to devote the time required, meeting by meeting, to properly consider the evidence of success (or not) in achieving outcomes and the trade-offs that have been made.

None of this difficulty will go away but the FCA has a better chance of solving it by approaching the challenge with its eyes open.

To discuss these issues further, contact Gavin Stewart.